Corporation Basics: What Type of Entity Should I Form?

Corporation

Most large businesses operate as corporations and it is most closely regulated business form. If the company’s business plan includes raising capital by someday admitting new owners or going public, then a corporation is a better business form.

The principal advantage to the corporation is the limited liability provided to its shareholders because it is considered a distinct legal entity that is liable for its own debts and taxes. A corporation’s creditors can only collect from the corporation’s assets not directly from the shareholders even if corporate assets are insufficient to pay of debts and liabilities. To maintain the liability shield for shareholders, proper operation of a corporation is crucial. The corporation should be appropriately capitalized for the type business it conducts. The corporate assets cannot be used for personal reasons or commingled with personal assets. Corporate and books and other record-keeping must be kept separate form personal books. Additionally, corporate actions must be appropriately authorized by the board of directors or the shareholders.

Shareholders elect the corporation’s board of director’s but otherwise do not actively manager the corporation. It is the board of directors that makes the major corporate decisions. The board of director’s in turn appoints officers to manage the day-to-day operations of the corporation. A single person can be a corporation’s owner and sole director, and may serve as any officer.

A corporation survives the death of a shareholder or other change sin ownership and can exist in perpetuity. A corporation is taxed as a separated legal entity unless it is an S corporation. Under federal tax law, a corporation is taxed on its net income. If the corporation distributed money or other property, such as dividends, it its shareholders, the shareholders will be taxed on these distributions.

Limited Liability Company (LLC)

A limited liability company is owned by members who own membership interests in the LLC. The advantage of an LLC is the managerial flexibility and the potential tax flexibility. LLC allows a business to have a pass-through federal income tax treatment of a partnership with the limited personal liability of a corporation. An LLC operated like a limited partnership without a general partner. Unlike an S corporation, an LLC has no limits on the number of shareholders, classes of stock, or type of shareholders. LLCs can be attractive for corporate investors and wealthy individuals because of its pass through characteristic. An LLC can also have corporations and partnerships as members unlike an S corporation. Additionally, it can incorporated, tax free, at any time.

The downside to an LLC is that you don’t get the free transferability of ownership, perpetual existence, and the ability to be totally owned by a single individual that you would get with a Corporation. Limited liability companies generally restrict the transfer of ownership interest in the business to qualify for the Partnership classification under federal tax law. Also, because of restrictions on tax-exempt members of venture capital funds, venture capital funds are prevented from investing in an LLC.

An LLC requires two documents. First, a one to two page document called a “Certificate of Formation” is filed with the Secretary of State indicating the name of the LLC, address, agent for service of process, term, and whether it will be run by members or managers appointed by members. Second, an LLC also requires an operating agreement that is similar to a partnership agreement. The operating agreement specifies how the LLC will be run, the financial obligations of the members, and how profits and losses will be divided. LLCs can be manger-managed, which means that all the members jointly run the business, or the members designate one or more managers to create a manager-managed LLC.

An LLC usually has a limited existence in that it will end after a specified number of years or upon the occurrence of some specific event. Being taxed as a Partnership makes the LLC structure attractive because it gives the business owners flexibility in allocating profits and losses. Operating an LLC also gives the owners greater flexibility in determining who manages the business and each owner’s duties.

S Corporation

An S corporation is a regular corporation that opts to tax its profits at the personal income tax level of its shareholders. It is set up on the same manner as a regular corporation but it also must file for IRS approval to be treated as an S corporation and shareholders must consent in writing to the S-corporation election. Although an S corporation must prepare tax returns, unlike a corporation, an S corporation does not pay federal income tax on net income. Thus, S corporation form bypasses the double taxation on both the corporate income and the shareholder distribution income that required of a corporation. An S corporation’s losses also flow through to the shareholders, who can deduct those losses from their personal tax return subject to certain limitations. Profit and losses are allocated based on share ownership. Shareholders must include on their individual tax returns the profits of the S corporation even if no money was distributed to them.

In order to qualify as an S corporation, the following criteria must be met:

1. Corporation applying for S corporation election must be a domestic corporation.
2. An S corporation may not have more than 75 shareholders who are individuals, certain tax-exempt organizations, certain trusts or estates, and none of whom are non-resident aliens.
3. An S corporation may issue only one class of stock.
4. An S corporation may not owned by a C-corporations, other S-corporations, LLCs or partnerships.

Because all shareholders of an S corporation must be individuals, an S corporation cannot raise funds from venture capital funds, corporations or institutional investors. The one-class-of-stock requirement prevents the business from issuing inexpensive founders’ stock for key employees.

Like a corporation, an S corporation continues until formal dissolution. It is not affected by the death or disaffiliation of a shareholder.